Federal Reserve Board Report – The Depth of Negative Equity and Mortgage Default Decisions

In other words the “lenders” business model has failed because of the frauds they perpetrated on America… They had it sooo good but took it way too far…

Finance and Economics Discussion Series
Divisions of Research & Statistics and Monetary Affairs
Federal Reserve Board, Washington, D.C.

The Depth of Negative Equity and Mortgage Default Decisions

Neil Bhutta, Jane Dokko, and Hui Shan

May 2010

Abstract

A central question in the literature on mortgage default is at what point under-water homeowners walk away from their homes even if they can afford to pay. We study borrowers from Arizona, California, Florida, and Nevada who purchased homes in 2006 using non-prime mortgages with 100 percent financing. Almost 80 percent of these borrowers default by the end of the observation period in September 2009. After distinguishing between defaults induced by job losses and other income shocks from those induced purely by negative equity, we find that the median borrower does not strategically default until equity falls to -62 percent of their home’s value. This result suggests that borrowers face high default and transaction costs. Our estimates show that about 80 percent of defaults in our sample are the result of income shocks combined with negative equity. However, when equity falls below -50 percent, half of the defaults are driven purely by negative equity. Therefore, our findings lend support to both the “double-trigger” theory of default and the view that mortgage borrowers exercise the implicit put option when it is in their interest.
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Introduction

House prices in the U.S. plummeted between 2006 and 2009, and millions of homeowners, owing more on their mortgages than current market value, found themselves “underwater.” While there has been some anecdotal evidence of homeowners seemingly choosing to walk away from their homes when they owe 20 or 30 percent more than the value of their houses, there has been scant academic research about how systematic this type of behavior is among underwater households or on the level of negative equity at which many homeowners decide to walk away.
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Focusing on borrowers from Arizona, California, Florida, and Nevada who purchased homes in 2006 with non-prime mortgages and 100 percent financing, we bring more systematic evidence to this issue. We estimate that the median borrower does not walk away until he owes 62 percent more than their house’s value. In other words, only half of borrowers in our sample walk away by the time that their equity reaches -62 percent of the house value. This result suggests borrowers face high default and transaction costs because purely financial motives would likely lead borrowers to default at a much higher level of equity (Kau et al., 1994). Although we find significant heterogeneity within and between groups of homeowners in terms of the threshold levels associated with walking away from underwater properties, our empirical results imply generally higher thresholds of negative equity than the anecdotes suggest.

Full report below…

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Federal Reserve Board Report – The Depth of Negative Equity and Mortgage Default Decisions
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